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4 Critical Errors You Must Avoid

Make the most of your advantages over Wall Street. Start by avoiding these four common errors.

For all of the attention lavished on the guys who manage hedge funds and mutual funds, nothing beats being a small investor. Peter Lynch said as much in his classic, One Up on Wall Street: Big institutions have the resources, but we have the potential for extraordinary returns.

Poor Warren Buffett?For one thing, we can invest in any company we like. Warren Buffett would love to be able to say that. Instead, his company, Berkshire Hathaway, holds billions in cash because Buffett can't find anything cheap enough to buy. With so much to invest, Buffett must focus on large-cap, super-liquid companies. It must be dreadful having so much money.

Even better, unlike huge institutional money managers, we don't have to perform every quarter. We don't have to jump on every fad or pretend to be "active" out of a fear of falling behind. We don't worry what our manager or clients think of us. We can focus on buying the best companies at the cheapest prices.

Don't look this gift horse in the mouthDigging up these rare values is what I -- along with Philip Durell and thousands of "small" value investors -- do every day at Motley Fool Inside Value. Sadly, too many individual investors don't fully exploit these advantages, and they never reach their true potential to trounce the market.

Trust me, you do not want to be one of those underachievers. Fortunately, by simply avoiding these four common mistakes -- all of which I've made myself at some point -- you can dramatically increase your long-term returns.

Mistake No. 1: Trying to time the marketEach week, hundreds of stocks move up or down 10%. If you could just figure out which stocks will move which way, you'd be rich in no time. Some even seem to bounce between price levels, the way Oracle has repeatedly bounced between $11 and $15 several times over the past few years. If you could just buy at the lows and sell at the highs, you'd have a profit machine!

It's a great idea ... except that it doesn't work. Over the short term, price changes are essentially random. People are masters at spotting patterns, even in random data. Look at a chart long enough, and a winning strategy will appear -- only to evaporate when real money is at stake. Sometimes you win with such a strategy, and sometimes you lose. So it goes with random events.

When investing, you want your results to be less like the flip of a coin and more like the flip of a cat. There's some chance of the poor kitty bonking his head, but the smart money says that he'll land on his feet. So don't time the market. Focus on a proven strategy like value investing, where the expected return is significantly higher than average.

Mistake No. 2: Ignoring costsFees, trading costs, and taxes are the bane of the small investor. People "manage" your assets because they want their cut. This can take many forms: fund expenses, trading commissions, account management fees, and the spread between bid and ask prices on stocks. If there's any profit left, the government is quite eager to step in and take its share.

Always be aware of the fees you'll be paying. Recognizing that higher costs mean lower returns, you should plan to minimize fees and taxes. Buy funds with low expenses. With your personal portfolio, avoid needlessly swapping American Eagle Outfitters(NASDAQ:AEOS) for Abercrombie & Fitch(NYSE:ANF) -- two companies in the same industry, with similar market caps, with comparable performance trends. You'd be amazed how frequently fund managers do precisely that, and how much it costs you in taxes and commissions.

Mistake No. 3: Buying the hypeChina is growing wildly, and Baidu.com is a big player in the Chinese Internet industry. Satellite radio is the next mass-communications medium. The Internet revolution will seem like a blip compared with what's going to happen with nanotechnology. With oil so high, the need for alternate, renewable energy sources becomes even more pronounced.

All that's true. But that doesn't mean you can buy Beacon Power(NASDAQ:BCON) simply because its flywheel energy storage systems seem promising, and expect to make a quick fortune. After all, Foundry Networks and 3Com(NASDAQ:COMS) were major networking equipment suppliers at a time when the Internet exploded and the world's communications shifted from analog to digital. Yet investors who bought at those companies' highs still lost money.

Hype usually involves some truth, but it says little about whether something will be a good investment. When confronted with large demographic, political, or technological trends, never just assume that the trend will provide a sufficient tailwind to power your portfolio.

Instead, examine the company-specific factors. A tailwind is nice, but it's critical to understand the competitive advantages of companies in the space. Ask yourself why this company will be able to exploit the trend better than its competitors. Whole Foods(NASDAQ:WFMI) recognized in the 1990s that some consumers were willing to pay for organic and natural foods and that the market segment was growing. The company's wholesome, attractive supermarkets hit the trend perfectly, leading to impressive returns for shareholders. Well-intentioned imitators have not been so fortunate.

Mistake No. 4: Betting on the market as a casinoThe stock market can feel like Vegas. A gambler can go to Harrah's and get lucky tossing dice. An investor can, in complete ignorance, buy a stock, get lucky, and make money. You don't get turned away from either for lack of knowledge or even common sense -- only lack of cash.

Unlike many Fools, I think it's perfectly reasonable for people to gamble on the stock market for entertainment, just as I think it's perfectly reasonable for people to gamble at casinos for entertainment. But I think gamblers in either case shouldn't be surprised, upset, or outraged if they lose money.

So if your goal is to make extraordinary profits, don't treat the stock market like a casino. Don't buy on hunches or speculations; buy because you understand the company and recognize that it's selling at a discount to its fair value. Always have a good grasp of (1) the company's fair value, (2) its strategy, and (3) the challenges it is likely to face going forward.

Again, I follow this process myself every day -- in my work at Inside Value and when managing my own portfolio. In my experience, this is the only way to buy stocks that offer a superior risk-reward trade-off.

What next?By simply avoiding these four mistakes, you can dramatically improve your chance of success. Focus on value stocks with a suitable margin of safety, and look at the entire market. Then you can really exploit your advantage as a small and nimble investor. Peter Lynch (and Warren Buffett) would be proud.

If you're interested in finding dirt cheap value stocks, you should chat with one of my favorite investors, Philip Durell. Philip is offering a free 30-day trial to his Motley Fool Inside Valueinvestment service. There's no easier way to discover whether an advisor or a service is right for you. Simply click here to learn more.

This article was originally published on April 26, 2005. It has been updated.

Fool contributor Richard Gibbons, a member of the Inside Value team, has no position in any of the stocks discussed in this article. He tosses cats only infrequently, and no felines were injured during the writing of this article. Whole Foods and American Eagle are Stock Advisor selections. Baidu.com is a Rule Breakers choice. Berkshire Hathaway is an Inside Value pick. The Motley Fool has a disclosure policy.